September 26, 2006

Yesterday I nodded approvingly to the following remarks on the consequences of trade and current account deficits from Nouriel Roubini, as recounted by the Wall Street Journal:

"Your standard of living is going to be reduced unless you work much harder," says Nouriel Roubini, chairman of Roubini Global Economics. "The longer we wait to adjust our consumption and reduce our debt, the bigger will be the impact on our consumption in the future."

Reader Jim K responded...

"Your standard of living is going to be reduced unless you work much harder...."

Doesn't that depend on what we do with the proceeds of all this borrowing? If it is invested productively, then we won't have to reduce our consumption.

... and reader Gerald MacDonnell seconded the objection:

I agree with Jim. If anything he understates the point. The question boils down to what returns we earn on capital investment here. The tendency for capital deepening to raise labor returns is independent of who owns the capital. And even the net financial return seems likely to rise, despite the rising net tribute paid to foreigners.

Well, those are mighty fine points, and I was mighty remiss in not making them. So then, is it likely true that the sharp increase in the U.S. current account deficit that commenced in about 1997 has deepened the capital stock beyond what it otherwise would have been? knzn responds to Jim and Gerald's comments:

Although the other commentators make theoretically correct points, I think they are wrong empirically. Over the past few years, the US capital surplus (i.e., “borrowing”) has mostly been invested in residential real estate, which is not nearly as productive a use as one might hope for. Residential investment won’t do a whole lot to raise labor returns in the future.

Because investment by businesses in equipment and structures has been relatively low in recent years (for cyclical and other reasons) and because the tax and financial systems in the United States and many other countries are designed to promote homeownership, much of the recent capital inflow into the developed world has shown up in higher rates of home construction and in higher home prices. Higher home prices in turn have encouraged households to increase their consumption. Of course, increased rates of homeownership and household consumption are both good things. However, in the long run, productivity gains are more likely to be driven by nonresidential investment, such as business purchases of new machines. The greater the extent to which capital inflows act to augment residential construction and especially current consumption spending, the greater the future economic burden of repaying the foreign debt is likely to be.

This is a really intriguing question: Should we care if investment takes the form of physical capital that will ultimately be devoted to producing goods and services sold in markets, as opposed to physical capital that will ultimately be devoted to "home production" (that is, the manufacture of all those things that make us happy that households create for themselves)?

I'm not so sure. It would be true that increased quantity and quality in residential housing would do little to raise productivity in market activities, but surely it must raise productivity in home production. It would also be true that devoting more resources to home production means fewer resources for market production. In other words, if we decide to enjoy the "output" a larger yard, a more inviting family room, a gourmet kitchen,or whatever, we may have to cut down on our consumption of other things. But so what? That's a choice that individuals make all the time, and the truth is that economists don't have much to say about whether it is a good thing or a bad thing: De gustibus non est disputandum.

I can think of at least a couple of reasons to not be indifferent about the market/home investment distinction. For one thing, as mentioned by Mr. Bernanke, the deck is already stacked in favor of housing via tax incentives, institutions like Fannie Mae, and so on. A boom in a distorted market may not be such a great thing.

Perhaps more important from the financial stability point of view, home production is, by definition, non-tradable, so investment in housing has a limited capacity to directly generate the means to pay back foreigners who lend to us. That's the sense in which I was agreeing with Roubini and knzn -- the payback would have to come in the form of reducing our own consumption of market goods (again, below what it would otherwise be). Again, that is not a bad thing per se, but there is some possibility that this makes the whole set of transactions riskier from the point of view of the lenders, raising borrowing costs and inducing market volatility. There is yet scant evidence that this is the case, but I suppose it is a possibility.

Others may have additional reasons for worrying about a shift from market to home production. I'd like to hear them. But for now, I take the point that conclusions about the "problem" of the current account deficit are not clear cut. Consider me duly chastened.

UPDATE: Be sure to read the very thoughtful contributions to the comment section.

Comments

A few points:

1. The textbook separation of "sources and uses" of funds (i.e. the fungibility of money) means that statements like "the US capital surplus (i.e., 'borrowing') has mostly been invested in residential real estate" can't really be justified. Presumably the funds go to some combination of C, I, and G that we'll never know.

2. To the extent the funds do augment the housing stock, I would argue that the main impact is temporary. If we're left with "too much" housing then we will build less in the future, and use our resources to do something else (hopefully more productive). I don't see why the effects would be permanent.

3. If we have for some reason moved to a permanently higher share of resources devoted to housing, then, as you say, we will have to have less of other stuff, but that would be the result of our preferences. The tax distortions have been there for a long time, and haven't increased, so they can't be responsible (though it's conceivable rumors of their demise could be pushing some investment forward).

Jim -- We can compare changes. And at the margin, the post-2000 increase in the current account deficit has been associated with:

a) a fall in household savings (i.e. a rise in consumption v income)
b) a fall in government savings (i.e. the tax cuts/ war/ etc)
c) a rise in in residential investment
d) a fall (relative to 2000 levels) in non-residential investment. business inv. has picked up a bit since its lows, but it remains well below its late 90s level.

so I think it is fair to say the recent surge in external debt has been associated with a surge in consumption/ residential investment.

that is my concern: external debt is not a claim on the overall US economy. It is a claim on the external portion of the US economy -- i.e. the United States ability to generate enough export revenue (and revenue from US investment abroad) to pay our external debts and afford the imports we want/ need. it isn't obvious that the surge in debt recently has been associated with a surge in our future capacity to generate exports.

that said, in fairness, it has been associated with a surge in the market value of US external assets. that is more tied to the surge in non-US equity market valuations/ currency moves than any increase in the cash revenues produced by US investment abroad, but it is worth noting.

Dave -- this applies more to your preceding post than your current post, but without jumping into scare mongering, i do think that there is some risk of a significant increase in the US income deficit in the near future. I laid out my thinking in a recent post, but the key points include:

a) by my calculations, a rise in the average interest rate on US external borrowing to around 5% (v a bit over 4% in the first half of 2006) would lead to a deterioration of around $60b in the US income balance.

b) barring any offsetting rise in the income stream from US investments abroad relative to foreign investment in the US, ongoing currnet account deficits in the $900b-1,000b range imply -- depending on the marginal cost of US borrowing -- an increase of roughly $50b in the US interest bill per year. Long-term rates are under 5% on treasuries, but if you add in short-term borrowing and MBS/ agencies, i think the average cost of funds for the US is a bit above 5% right now at the margin.

c) a 1% increase in the average int. rate on US borrowing would increase the US interest bill by about $40-50b a year. That comes from higher interest costs of the portion of the US external balance sheet that is financed with debt -- i.e. the debt for equity swap (higher rates on the debt, no higher returns on the equity) and the US net debt position. those positions currently are in the $4.5 trillion range.

I am assuming that the averate int. rate on Us lending would rise commensurately, so the portion of US external borrowing that is matched by lending would not contribute to the deterioration.

add it up, and it seems to me that a significant deterioration is likely simply from the normalization of US interest rates on the external side, something that is playing out a bit more slowly than I expected....
I would consequently expect an income deficit of around $100b next year, even if nothing "bad" happens -- just from an increase average US extenral interest rates toward 5%.

Plus, as the US net debt position deteriorations/ a growing share of US equity investment abroad is financed with debt, the US exposure to an interest rate shock rises.

Seconding Brad Setser's comment to Jim K, I think that whether, "de gustibus non est disputandum", household investment of borrowed funds is as "good" as any other, depends on the certainty and ease with which the borrower will be able to service the debt. It's important to note that from an external lenders perspective, investment in nontradables is indistuinguishable from consumption [*].

Normatively, a borrow who borrows to finance "in kind" returns, as might be supplied by a nice home, a vacation, or a good meal on a credit card, should not be criticized, so long as the burden she is taking on is one she can reasonably service. But a borrower whose capacity to its service her debt-load is in doubt ought to be criticized for such borrowing, as investing to secure in-kind returns without exchange value leaves ones external balance sheet encumbered by an additional liability with no corresponding asset, damaging the position of creditors.

Exactly the same argument applies to the United States' use of steep credit lines to finance consumption and nontradable investment. The magnitude of the United States debt load and the pace of its increase calls into question our ability to service our obligations (without partially defaulting by devaluing credit claims). Under these circumstances, borrowing for in-kind returns is putting other people's capital at risk for benefits they cannot share. It is behavior as much deserving of criticism and a heavily indebted low-wage worker putting a trip to Vegas on the fifth credit card.

One might ague that the "dollar is our currency, but their problem", so these concerns are overstated. I think that's right as far as it goes. But it does not go very far. The US has a capacity that overleveraged workers don't have, to devalue the claims against it with much less disruption than an individual declaring bankruptcy. The US might well end up having gotten lots of in-kind returns for pennies on the dollar, by playing and winning a zero-sum financial game with its foreign creditors. But zero-sum games are not what trade is supposed to be about. If the US "wins" this way, it will damage not only its future credibility as a borrower, but the case for trade as a positive sum enterprise with benefits for all. It is those who currently championing this moment's "free trade" who are most seriously damaging the long-term case for trade as economists like to envision it.

That was much more of a rant than I intended... I just don't think you should feel "chastened" for your previous expressions of worry, and speaking of in-kind returns, I hope you are hardly chaste at all!

---

[*] One could quibble -- to some degree nontradables can be considered an investment in future tradables production, as no tradables could be produce if American workers had no homes. But this is analogous to noting that American workers couldn't produce if they didn't buy food. We still mostly consider food expenditures consumption, not investment, and rightly so since we spend dramatically more than the minimum required to sustain production with some spartan lifestyle. Same argument goes for housing.

Brad, Forget the "rise in Residential Investment". We ALL now know it wasn't fundamentals that elevated house prices to these absurd levels. Our housing Bubble was driven by political shenanigans & rampant investor speculation, income can't support it & it WILL be reversed.
Tim Iacono reminds us this morning of the dilemma BB's Fed faces. Is Fed credibility at stake because of BB's misread & speak straight to us about our future prospects? (It's pretty obvious the Bond market doesn't think so, it's betting Bernanke works for them & will start major easing SOON.) Here's an excerpt from Iacona, link follows.
"From the fine blog of Calculated Risk comes this tidbit from last year where then-White House economic advisor Ben Bernanke offered his thoughts on the price of real estate.
Friday July 29, 2005
Bernanke: House Prices Unlikely to Decline.
Bernanke was on CNBC today. From Reuters:
Top White House economic adviser Ben Bernanke said on Friday strong U.S. housing prices reflect a healthy economy and he doubts there will be a national decline in prices.
"House prices have gone up a lot," Bernanke said in an interview on CNBC television. "It seems pretty clear, though, that there are a lot of strong fundamentals underlying that.
"The economy is strong. Jobs have been strong, incomes have been strong, mortgage rates have been very low," the chairman of the White House Council of Economic Advisers said.
The pace of housing prices may slow at some point, Bernanke said, but they are unlikely to drop on a national basis.
"We've never had a decline in housing prices on a nationwide basis," he said, "What I think is more likely is that house prices will slow, maybe stabilize ... I don't think it's going to drive the economy too far from its full-employment path, though."
Is it too early to start talking about the "Bernanke Put"?
The resurrection of this quote is certainly not a good indication of Mr. Bernanke's ability to predict the future - the timing of this assurance is particularly embarrassing. Graphically, with a little help from the Northern Trust, the situation looks like this:
Ironically, it has been almost exactly one year from when the Fed chief's prediction was offered. The report of two days ago, in which median home prices were seen to be declining on a year-over-year basis, was the very first full-year reporting period where Mr. Bernanke's assurances could have been put to the test and, unfortunately, the new Fed Chairman's advice looks to be as bad as the old Fed Chairman's."
My comment is that so far our Fed has refused to reverse its Banks' ridiculously loose mtg. lending criteria. Further, it has refused to state clearly that we can NOT go on expecting monetary policy to be the cure-all for profligate excesses of the Administration, GSEs, Congress, and carefree consumers. The Fed MUST tell the world, Business Cycles are painful but necessary.http://themessthatgreenspanmade.blogspot.com/2006/09/housing-report-that-mattered.html

For years I have rearanged the BEA savings and investment data
into a sources and uses presentation --it primarilly involves moving the fed deficit to uses rather then negative savings --and have found that it really makes the audience understand what is happening much easier.

For example, one of the observations that falls out of a "sources and uses" table is that in the 1990s boom foreign investment and the federal surplus financed about half of the capital spending boom.

Now this same presentation really makes it clear that the foreign investment is being used largely to finance the federal deficit and/or consumption, not investment.

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